Ethanol Makes A Comeback

One of the hit songs from the 1943 Rodgers and Hammerstein musical Oklahoma! describes corn that is "as high as an elephant's eye." It's not a bad image for the 2009 corn harvest, 13.1 billion bushels plucked off 86 million acres. This was not entirely a blessing for farmers, since bumper crops come with depressed prices. But it was good news for the beleaguered ethanol industry.

Thanks to congressional politics, the corn ethanol industry has been through a dramatic boom and bust in recent years. Initially favored by Senator Robert Dole and then promoted as a self-sufficient "green" source of energy independence, ethanol may or may not make the atmosphere more carbon-free. What is not in doubt is that it is federally required.

The Energy Independence & Security Act of 2007 laid out an ambitious schedule of mandated demand for ethanol. This triggered the equivalent of a gold rush, with ethanol plants springing up like weeds across the Midwest. Low barriers to entry, simple technology and a lack of engineering complexity enabled plants to be put up in as little as 12 months. By mid-2008 the boom was full on, driving ethanol demand from a normal 10% to 15% of corn usage to 35% at the peak. Predictably, corn prices exploded. Normally trading in a range of $2.50 to $3.50 a bushel, they went to $7.35 in June 2008.

The profitability of the ethanol business depends on the so-called crush spread, the price difference between a gallon of ethanol and the corn that goes into it. The crush spread got crushed. In November 2008 VeraSun, a high-flying new issue from 2006 and then the second-largest producer of fuel ethanol, filed for bankruptcy. In May 2009
Pacific Ethanol,
a producer funded by Bill Gates' Cascade Investments, followed suit. Aventine Renewable Energy also collapsed that spring.

What didn't change was the federal mandate. The U.S. consumes 138 billion gallons of gasoline per year. The government has decreed that "renewable" sources contribute 13 billion gallons in 2010, rising to 14 billion next year and reaching 20.5 billion in 2015.

Ethanol is not the only way to meet the mandate, but the alternatives (like diesel from algae) are not available on a large scale. The existing supply of ethanol is only 12 billion, and so prices are likely to rise. Ethanol now sells at $1.56 a gallon. Multiply that by 2.8, the number of gallons of alcohol you get per bushel of corn, and you get a yield of $4.37 a bushel. Subtract the $3.53 price for corn and you have a crush spread of 84 cents a bushel. That spread is likely to widen over the next year.

A year ago the petroleum refiner
Valero
bought seven ethanol plants from bankrupt VeraSun at what seems to be the low. It paid $477 million, or 61 cents per annual gallon of capacity. New construction costs $2 to $2.25 per gallon of annual capacity.

In a market that has rallied 90% from the low, finding discounted dollars is no easy task. But ethanol producers still have room to gain. Here are a few ethanol stocks I like.

Green Plains Renewable Energy (GPRE,16) is the fourth-largest producer of ethanol in the U.S., with an expected 480 million gallons of output this year. With an enterprise value (debt plus market value of common) of $811 million, you are purchasing that capacity at $1.69.

A company just now emerging from bankruptcy is Aventine, soon to be publicly traded. With a repaired balance sheet, Aventine should now have the liquidity to complete several unfinished plants and raise production from 200 million gallons currently to 415 million in 2012. I estimate that this capacity will be an enterprise price per gallon of $1.10 to $1.20.

Finally, there is
Archer Daniels Midland
(ADM, 28), one of the cheapest stocks in the S&P 500 (when measured by earnings growth and balance sheet strength). While not a pure play, ADM is by far the largest publicly traded producer, selling 40% of the ethanol going into gasoline today. The market cap of $18.2 billion comes to 1.24 times book value and 15 times trailing earnings.

A century ago Henry Ford declared ethanol to be the "fuel of the future." His forecast was just a little premature. In Brazil 84% of cars can switch from gasoline to ethanol with the toggle of a switch. But even if ethanol remains a mere additive in this country, it has a strong future.